C h a p t e r
06
AGGREGATE
SUPPLY AND
AGGREGATE
DEMAND
O u t l i n e
Production and Prices
A. What forces bring persistent and rapid expansion of real
GDP?
B. What causes inflation?
C. Why do we have business cycles?
D. How do policy actions by the government and the Federal
Reserve affect output and prices?
I.
Aggregate Supply
A. Aggregate Supply Fundamentals
1. The aggregate quantity of goods and services supplied
depends on three factors:
a) The quantity of labor (L )
b) The quantity of capital (K )
c) The state of technology (T )
2. The aggregate production function, Y = F(L, K, T ), shows
how quantity of real GDP supplied, Y, depends on
labor, capital, and technology.
3. At any given time, the quantity of capital and the
state of technology are fixed but the quantity of
labor can vary.
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4. The higher the real wage rate, the smaller is the
quantity of labor demanded and the greater is the
quantity of labor supplied.
5. The wage rate that makes the quantity of labor
demanded equal to the quantity supplied is the
equilibrium wage rate and at that wage the level of
employment is the natural rate of unemployment.
6. We distinguish two time frames associated with
different states of the labor market:
a) Long-run aggregate supply
b) Short-run aggregate supply
B. Long-Run Aggregate Supply
1. The macroeconomic long run is a time frame that is
sufficiently long for all adjustments to be made so
that real GDP equals potential GDP and there is full
employment.
2. The long-run aggregate supply curve (LAS ) is the
relationship between the quantity of real GDP supplied
and the price level when real GDP equals potential
GDP. Figure 21.1, (page 477/131) shows an LAS curve
with potential GDP of $10 trillion.
3. The LAS curve is vertical because potential GDP is
independent of the price level. Along the LAS curve
all prices and wage rates vary by the same percentage
so that relative prices and the real wage rate remain
constant.
C. Short-Run Aggregate Supply
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1. The macroeconomic short run is the period of time
during which real GDP has fallen below or risen above
potential GDP and the unemployment rate has risen
above or fallen below the natural unemployment rate.
2. The short-run aggregate supply curve (SAS) is the
relationship between the quantity of real GDP supplied
and the price level in the short run when the money
wage rate and other resource prices are constant and
potential GDP does not change. Figure 21.2 (page
478/132) shows a short-run aggregate supply curve.
3. Along the SAS curve, rise in the price level with no
change in the money wage rate and other input prices
increases the quantity of real GDP supplied—the SAS
curve is upward sloping..
4. The SAS curve is upward sloping because a rise in the
price level with no change in costs induces firms to
bear a higher marginal cost and increase production;
and a fall in the price level with no change in costs
induces firms to decrease production to lower marginal
cost.
D. Movement along the LAS and SAS Curves
1. A change in the price level with an equal percentage
change in the money wage causes a movement along the
LAS curve.
2. A change in the price level with no change in the
money wage causes a movement along the SAS curve.
Figure 21.3 (page 478/132) illustrates both.
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E. Changes in Aggregate Supply
1. When potential GDP increases, both the LAS and SAS
curves shift rightward.
a) Potential GDP changes, as shown in Figure 21.4
(page 479/133) for three reasons:
i) Change in the full-employment quantity of
labor.
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333
ii)
Change in the quantity of capital, either
in the capital stock or in the quantity of
human capital.
iii) Advance in technology.
b) All the factors that shift the long-run aggregate
supply curve have the same effect on the short-run
aggregate supply curve.
2. One additional factor influences the short-run
aggregate supply but not the long-run aggregate
supply—a changes in resource prices, such as the money
wage rate.
a) An increase in resource prices decreases short-run
aggregate supply, so an increase in the money wage
rate shifts the SAS curve leftward.
b) Figure 21.5 (page 480/134) shows such a shift in
the SAS curve.
II. Aggregate Demand
A. The quantity of real GDP demanded, Y, is the total amount
of final goods and services produced in the United States
that people, businesses, governments, and foreigners plan
to buy.
1. This quantity is the sum of consumption expenditures,
C, investment, I, government purchases, G, and net
exports), X – M. That is:
Y = C + I + G + X – M.
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2. Buying plans depend on many factors and some of the
main ones are:
a) The price level
b) Expectations
c) Fiscal and monetary policy
d) The world economy
B. The Aggregate Demand Curve
1. Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level.
2. The aggregate demand (AD) curve plots the quantity of
real GDP demanded against the price level. Figure 21.6
(page 481/135) shows an AD curve.
3. The AD curve slopes downward for two reasons: a wealth
effect and two substitution effects.
a) Wealth effect: A rise in the price level, other
things remaining the same, decreases the quantity
of real wealth (money, bonds, stocks, etc.). To
restore their real wealth, people increase saving
and decrease spending, so the quantity of real GDP
demanded decreases. Similarly, a fall in the price
level, other things remaining the same, increases
the quantity of real wealth. With more real wealth,
people decrease saving and increase spending, so
the quantity of real GDP demanded increases.
b) Intertemporal substitution effect: A rise in the
price level, other things remaining the same,
AGGREGATE SUPPLY AND AGGREGATE DEMAND
335
decreases the real value of money and raises the
interest rate. Faced with a higher interest rate,
people try to borrow and spend less so the quantity
of real GDP demanded decreases. Similarly, a fall
in the price level increases the real value of
money and lowers the interest rate. Faced with a
lower interest rate, people borrow and spend more
so the quantity of real GDP demanded increases.
c) International substitution effect: A rise in the
price level, other things remaining the same,
increases the price of domestic goods relative to
foreign goods, so imports increase and exports
decrease, which decreases the quantity of real GDP
demanded. Similarly, a fall in the price level,
other things remaining the same, decreases the
price of domestic goods relative to foreign goods,
so imports decrease and exports increase, which
increases the quantity of real GDP demanded.
C. Changes in Aggregate Demand
1. A change in any influence on buying plans other than
the price level changes aggregate demand.
2. The main influences are: expectations, fiscal and
monetary policy, and the world economy.
a) Expectations about future income, future inflation,
and future profits change aggregate demand.
i) Increases in expected future income increase
people’s consumption today, and increases
aggregate demand.
ii)
A rise in the expected inflation rate makes
buying goods cheaper today and increases
aggregate demand.
iii) An increase in expected future profits
boosts firms’ investment, which increases
aggregate demand.
b) Fiscal policy is the government’s attempt to influence
economic activity by changing its taxes, spending,
deficit, and debt policies.
i) A tax cut or an increase in transfer payments
increases households’ disposable income. An
increase in disposable income increases
consumption expenditure and increases aggregate
demand.
ii)
Because government purchases of goods and
services are one component of aggregate demand,
an increase in government purchases increases
aggregate demand.
c) Monetary policy is changes in the interest rate and
quantity of money.
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i) An increase in the quantity of money
increases buying power and increases aggregate
demand.
ii)
A cut in the interest rate increases
expenditure and increases aggregate demand.
d) Two world economy influences aggregate demand in
two ways:
i) A fall in the foreign exchange rate lowers the
price of domestic goods and services relative
to foreign goods and services, increases
exports, decreases imports, and increases
aggregate demand.
ii)
An increase in foreign income increases the
demand for U.S. exports and increases aggregate
demand.
3. When aggregate demand increases, the AD curve shifts
rightward and when aggregate demand decreases, the AD
curve shifts leftward. Figure 21.7 (page 483/137)
illustrates an increase and a decrease in aggregate
demand.
III. Macroeconomic Equilibrium
A. Short-Run Macroeconomic Equilibrium
1. Short-run macroeconomic equilibrium occurs when the
quantity of real GDP demanded equals the quantity of
AGGREGATE SUPPLY AND AGGREGATE DEMAND
real GDP supplied at the point of intersection of
the AD curve and the SAS curve.
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2. Figure 21.8 (page 485/139) illustrates a short-run
equilibrium.
a) If real GDP is below equilibrium GDP, firms
increase production and raise prices; and if real
GDP is above equilibrium GDP, firms decrease
production and lower prices.
b) These changes bring a movement along the SAS curve
toward equilibrium.
3. In short-run equilibrium, real GDP can be greater than
or less than potential GDP.
B. Long-Run Macroeconomic Equilibrium
1. Long-run macroeconomic equilibrium occurs when real GDP
equals potential GDP—when the economy is on its LAS
curve.
2. Figure 21.9 (page 485/139) illustrates long-run
equilibrium.
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3. Long-run equilibrium occurs where the AD and LAS
curves intersect and results when the money wage has
adjusted to put the SAS curve through the long-run
equilibrium point.
C. Economic Growth and Inflation
1. Figure 21.10 (page 486/140) illustrates economic
growth and inflation.
AGGREGATE SUPPLY AND AGGREGATE DEMAND
2. Economic growth occurs because the quantity of labor
grows, capital is accumulated, and technology
advances, all of which increase potential GDP and
bring a rightward shift of the LAS curve.
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3. Inflation occurs because the quantity of money grows
more rapidly than potential GDP, which increases
aggregate demand by more than long-run aggregate
supply. The AD curve shifts rightward faster than the
rightward shift of the LAS curve.
D. The Business Cycle
1. The business cycle occurs because aggregate demand and
the short-run aggregate supply fluctuate but the money
wage does not change rapidly enough to keep real GDP
at potential GDP.
2. A below full-employment equilibrium is an equilibrium in
which potential GDP exceeds real GDP. Figure 21.11a,
(page 487/141) illustrates below full-employment
equilibrium. The amount by which potential GDP exceeds
real GDP is called a recessionary gap.
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3. A long-run equilibrium is an equilibrium in which
potential GDP equals real GDP. Figure 21.11b, (page
487/141) illustrates long-run equilibrium.
4. An above full-employment equilibrium is an equilibrium in
which real GDP exceeds potential GDP. Figure 21.11c,
(page 487/141) illustrates above full-employment
equilibrium. The amount by which real GDP exceeds
potential GDP is called an inflationary gap.
5. Figure 21.11(d) (page 487/141) shows how, as the
economy moves from one type of short-run equilibrium
to another, real GDP fluctuates around potential GDP
in a business cycle.
E. Fluctuations in Aggregate Demand
1. Figure 21.12 (page 488/142) shows the effects of an
increase in aggregate demand. Part (a) shows the
short-run effects and part (b) shows the long-run
effects.
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341
2. Starting at long-run equilibrium, an increase in
aggregate demand shifts the AD curve rightward.
3. With real GDP below equilibrium GDP, firms increase
production and rise prices—a movement along the SAS
curve.
4. Real GDP increases, the price level rises, and in the
new short-run equilibrium, there is an inflationary
gap.
5. The money wage rate begins to rise and short-run
aggregate supply begins to decrease. The SAS curve
shifts leftward.
6. The price level rises and real GDP decreases until it
has returned to potential GDP.
F. Fluctuations in Aggregate Supply
1. Figure 21.13 (page 489/143) shows the effects of a
decrease in aggregate supply.
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2. Starting at long-run equilibrium, a rise in the price
of oil decreases short-run aggregate supply and the
SAS curve shifts leftward.
3. Real GDP decreases and the price level rises. The
combination of recession combined with inflation is
called stagflation.
IV. U.S. Economic Growth, Inflation, and Cycles
A. Figure 21.14 (page 490/144) is a scatter diagram of real
GDP and the price level each year from 1960 to 2001. The
figure also interprets the data in terms of shifting AD,
SAS, and LAS curves. The data show economic growth,
inflation, and the business cycle. Between 1960 and 2001:
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1. Real GDP and potential GDP grew from $2.4 trillion to
$9.3 trillion.
2. The price level rose from 22 to 109.
3. Business cycle expansions alternated with recessions.
B. Economic Growth
Real GDP growth was rapid during the 1960s and 1990s and
slower during the 1970s and 1980s.
C. Inflation
Inflation was the most rapid during the 1970s.
D. Business Cycles
Recessions occurred during the mid-1970s, 1982, 1991–
1992, and 2001.